Case Study-The Story of GEICO, Graham, and Buffett

Geico is a company that is owned by Warren Buffett’s Berkshire Hathaway. It’s an incredibly interesting company to study. I recently read an outstanding presentation on the company by David Rolfe of Wedgewood Partners. This post is my take… a short summary of the story of GEICO from the notes of that presentation. I recommend studying the presentation for more details on the company itself-I learned a lot by doing so. It’s a great case study. Now… for the story, and the broader lesson….

Throughout its 80 year history, GEICO has dominated the car insurance industry by directly selling insurance to consumers at a lower cost than its competitors. This business model was laughed at in its early years, as analysts said GEICO could never compete with the larger insurance firms and their armies of sales agents. But GEICO did compete, took market share, and grew and grew and grew.

GEICO-The Growth Stock Loved by Two Value Investors

But the reason the company is a fascinating case study is that it made a fortune for both Ben Graham and Warren Buffett. Not only that, but GEICO, for most of its storied history, was considered a high flying expensive growth stock. Buffett occasionally got interested in growth businesses, more so as his career evolved, but Graham was basically allergic to stocks selling for high price to earnings ratios or high price to book ratios.

So it was ironic that Graham ultimately made far more money in this single GEICO investment than all of the other investments he made during the course of his lengthy career… combined. It was also strange that Graham invested nearly 25% of his partner’s capital into GEICO in 1948, acquiring 50% of the growing enterprise for the small sum of just $712,000. This would eventually grow to over $400 million 25 years later!! That is a 500 bagger. To make an understatement: For a guy who made a living hitting base hits, this was a home run.

Around this same time, a young 21 year old Warren Buffett became interested in GEICO after learning that Graham was chairman of the board. Buffett famously took the train to DC on a cold winter Saturday morning and luckily met Lorimer Davidson, an executive at GEICO who spent 4 hours with this “highly unusual young man”.

Buffett began buying stock the next Monday after being “more excited about GEICO than any other stock in my life”. He put 65% of his small fortune of $20,000 into Geico (the initial seedlings that would grow into his massive fortune). He also tried to sell the stock to every one of his clients, and wrote this excellent research report called The Security I Like Best.

So GEICO caused Graham to put 25% of his capital into the business when no other security ever represented more than 5% of his well diversified portfolio. And it caused a young Buffett to put the majority of his capital into the stock, also violating his mentor and role model’s investment policy.

But it paid off for both, although much more for Graham, as Buffett sold the stock after a small gain to invest in even more undervalued securities. Buffett would later regret this decision as his initial $13,000 investment would have grown to $1.3 million in just a few short years. (Buffett of course ended up buying GEICO stock again years later, acquiring a major stake in the 70’s during a panic selling spree, and finally buying the whole thing in the 90’s.)

I Like Cheap Stocks and I Like Base Hits

My own investment strategy much more resembles the methodical, statistical approach that Graham and Walter Schloss (and an early Buffett) used to produce consistent returns than the present day Buffett and many of the Buffett followers. Buffett is an anomaly in that his judge of business and people (management) is unparalleled. This gives him a huge edge. He sees intangibles and is able to quantify those intangibles and deduce them down to actionable pieces of information that in turn helps him determine value. It’s based on his lifetime of learning, reading, and experience, and just raw talent.

This is a tough thing to master-the qualitatives. Many try, but end up hugging the index because they buy these great companies at just mediocre prices and thus get average results… the stocks of the companies end up producing great results-high returns on capital and large profits, but because of the valuation paid by these investors, the shareholders returns are inferior to the splendid business results.

So the first thing I always try to do is be careful not to overpay for great businesses. I’m not Buffett, and I don’t try to be. I love great businesses, but I don’t want to overpay. So that leaves me buying cheap stocks, and methodically grinding out investment profits in the style of Graham and Schloss, which is something I enjoy doing very much.

The Lesson of GEICO: Always Be Prepared for the Fat Pitch

However…. here is the lesson: while it’s a prudent and safe strategy to methodically invest in a diversified basket of undervalued stocks– that is, to invest in value stocks, sell them as they approach fair value, and reinvest profits into further undervalued stocks– it is also prudent to be alert and always prepared for an opportunity to hit the home run ball.

Buffett hit a lot of home runs during the course of his career. Graham hit one. Buffett’s a home run hitter. He’s Barry Bonds (without the steroids). Ben Graham is Tony Gwynn. Tony never hit more than 17 home runs in his hall of fame career, and he hit more than 10 home runs in just 5 out of his 20 years that he played. But after batting .289 in his rookie year, he batted over .300 in 19 consecutive years, including .394 in 1994. Gwynn had an incredible career batting average of .338, and he got on base nearly 4 out of every 10 times he stepped to the plate.

That’s a lot of value. And that’s what Graham did. Methodically hit base hit after base hit. But always be prepared for opportunity when it comes.

I’ll end the post with one of my favorite passages from The Intelligent Investor, (which was also featured in the Rolfe presentation I linked to above)-emphasis mine:

Ironically enough, the aggregate of profits accruing from this single investment-decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.

Are there morals to this story of value to the intelligent investor? An obvious one is that there are several different ways to make and keep money on Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision – can we tell them apart? – may count for more than a lifetime of journeyman efforts. But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplines capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgment, and the courage to take advantage of them.

I would like to know which metric do you consider a company to be undervalue. I have 26 way to value a company and I still which ones to pick. I use 3% free cash flow growth even if the company is has a 20% growth, I also add book growth and sometimes the dividend. Other metrics I also liek to include are roi and earning yield.
Do you think you can share your ideas please.

There are a number of variables like you say to determine the value of a company. Different companies need to be valued in different ways. Sometimes I like to look at tangible assets, sometimes I like to focus more on earnings yield. My valuation is usually very simple, and stems from either earnings or assets, sometimes a combination. I like to look at returns on capital to determine quality, and I like looking at P/B and EBIT/EV for earnings yield. Earnings yield can be measured using free cash flow as well, but the key is to use the total enterprise value, which reflects equity and debt (the cost that a private buyer would have to pay for the company).

It’s not quite this simple, but the basic value metrics represent the big picture, and that’s most of the battle. The other key is keeping disciplined and be willing to own what most others don’t want (according to Templeton, that’s how we make money as value investors).

John, thank you, very interesting!
I have a doubt. I can’t figure out what’s the GEICO’s moat, because I don’t understand what prevented another company anytime to do the same as GEICO. That is, to sell directly, without agents or branch offices.
Regards,